What Is A Real Estate Investment Trust and Why Invest? | MoneyWizard.ca (2023)

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Canadian Real Estate Investment Trusts (REITs) aren’t for everybody. But for some, they’re a blessing in disguise.

You may know someone who vows to stay away from anxiety-inducing equities and to stick with real estate. Such investors seek comfort in owning tangible assets that provide them with a fixed monthly rent.

But others find direct investments in real estate to be cumbersome. After all, real estate is illiquid and requires active management.

Enter REITs (pronounced “reets”), a middle ground that gives investors wary of illiquidity an opportunity to invest in real estate without having to actively manage properties or invest a large amount of capital.

What Are REITs?

REITs are companies that own and often operate income-generating real estate. Think of them as a mutual fund that holds real estate instead of equities or bonds. (To learn more about mutual funds, check out this MoneyWizard guide.)

REITs are actively managed by industry professionals who identify opportunities and invest in commercial real estate. REITs lease these properties to generate rental income.

In addition to the rental income, REITs also benefit from capital gains if the value of the owned properties appreciates over time.

How Do REITs Work?

As an investor, you can buy units of a REIT from an exchange. Owning these units entitles you to part ownership of the properties owned by the REIT and to collect a part of its rental income.

Some REITs invest your funds in a single sector of real estate, such as healthcare, infrastructure, apartment buildings, and office complexes. Other REITs diversify by investing in several sectors of real estate.

REITs must pay out a minimum of 90 percent of their taxable income to investors. This makes them a convenient fixed-income investment vehicle if you want a steady source of income.

Some REITs—mortgage REITs—also finance real estate purchases instead of investing in them. Speaking of which . . .

Types of REITs

What we have discussed thus far are equity REITs. Although they are the most popular type, there are other types of REITs you can invest in.

Equity REITs

Equity REITs purchase properties and lease them to tenants. Rental income is the primary source of income for equity REITs, but not the only one. REITs can also earn capital gains as a result of appreciation in the prices of the properties they own.

Equity REITs pay out most of their earnings to shareholders after deducting management and operating expenses. The standard practice for US-based REITs is to distribute earnings quarterly, but Canadian REITs distribute earnings monthly.

Mortgage REITs

The primary difference between mortgage REITs (mREITs) and equity REITs is that the latter directly hold and manage properties, whereas mREITs hold mortgages on real estate purchased by some other entity.

An mREIT behaves more like a financier than an investor. This fact makes its business model a little more complex than the business model of an equity REIT.

Because mREITs own no real estate, you won’t benefit from any appreciation in real estate prices by participating in this investment vehicle. An mREIT is also more sensitive than an equity REIT to fluctuations in the interest rate.

Let’s consider an example of a mortgage REIT.

Let’s say that a mortgage REIT pools $5 billion from investors and borrows an additional $10 billion at 4 percent from other sources. It buys $15 billion worth of mortgages that have a 6 percent yield. So:

This is a simplified example that does not take into account the management, operating, and other expenses of the REIT. In any case, mREITs tend to be riskier than equity REITs and offer higher potential return.

Hybrid REITs

Hybrid REITs are a combination of equity REITs and mortgage REITs. They purchase real estate as well as mortgages and earn rental income as well as interest income. Generally, hybrid REITs allocate most of their capital to one type of investment or the other, i.e., to real estate or to mortgages.

Other REITs

REITs can also be categorized with respect to their sector and trading status. The most common sectors that REITs invest in are hospitality, retail, residential, healthcare, and office. The three main categories with respect to trading status are:

• Publicly Traded REITs. These are the most popular kind of REIT to invest in. They are listed on a securities exchange like TSX, where retail investors can buy and sell them in real time. Publicly traded REITs are very liquid. They enable investors to gain real-estate exposure without investing large funds in illiquid property.
• Public Non-traded REITs. Although public non-traded REITs can be traded by the public, they aren’t listed on a stock exchange. Although they are not as liquid as publicly traded REITs, they tend to offer more stability since they remain unaffected by market volatility.
• Private REITs. These REITs are unavailable to retail investors. A risky and expensive affair, private REITs are accessible only to qualified investors.

Pros of Investing in REITs

Investing in REITs offers unique benefits.

Accessibility

REITs were created to give retail investors access to a class of assets otherwise out of their reach. How many of us can purchase an office at the Scotia Plaza or even at a much smaller commercial complex?

Thankfully, we now have REITs, which enable us to invest in pieces of properties throughout Canada and to earn rent from them.

Liquidity

If you’ve ever sold a property, you know how illiquid real estate can be, especially in a difficult market. REITs eliminate this obstacle. Publicly traded REITs can be bought and sold in real time through exchanges. If you ever need the money that you have invested in a REIT, you can redeem it with the click of a button.

Exemption from Corporate Tax

When you put your money in dividend stocks, your earnings are taxed twice: once when they’re earned by the corporate entity, again when they’re paid out to you as dividends. REITs pay zero tax regardless of their profitability so long as they pay out all of their earnings as dividends.

Benefits of Diversification

Adding REITs to your portfolio can reduce its overall risk. Without access to REITs, most small investors could not have used real estate to diversify their portfolios. REITs facilitate diversification by allowing small-ticket investment in real estate.

Steady Stream of Income

All REITs pay at least 90 percent of their taxable income to their shareholders. This usually means a dividend yield that is higher than the yield of good old dividend stocks on the TSX. You can earn a steady income with REITs or even reinvest the dividends to compound their value over time.

Potential for High Returns

Dividends are not the only way that REITs generate earnings; they can also enjoy capital gains. As the value of properties held by a REIT appreciates, it can sell the properties to realize capital gains and reinvest the proceeds. Some REITs even develop properties themselves.

Capital gains plus dividends add up to returns that are nothing to sneeze at. Some REITs have even managed to consistently beat the market over the past three decades.

Cons of Investing in REITs

REITs are an excellent investment vehicle. But to safeguard your capital and maximize your returns, you should keep in mind the downsides of this form of investment.

More Suitable for Long-Term Investors

Although REITs are highly liquid, you should not invest money in them that you need in the short term. Like equities, real estate has good times and bad. Liquidating your investments in the short run could erode your capital. Ideally, you should invest money that you won’t need for at least the next five years—and the longer the better.

Sensitive to Fluctuations of the Interest Rate

It’s a common misconception that REIT stock prices and interest rates are inversely correlated. Sometimes this is true, but not always. The relationship is a little more complex.

The data suggest that REIT stock prices and interest rates are positively correlated in a growing economy and negatively correlated in a slowing economy. When you invest in a REIT, you should monitor interest rates and other macroeconomic indicators to analyze how they may affect the value of the REIT.

Taxation

Although the REIT itself can dodge the tax bullet, the income of shareholders will be taxed. The distributed earnings are added to your tax return as income from property and will be taxed at the ordinary rate of tax. This is why it’s advisable to hold REITs within a tax-deferred account like a TFSA or an RRSP.

REITs also tend to be less tax-efficient than actively managed real estate. To lower your taxable income, you can claim depreciation from year one, along with other management expenses.

Sectoral Risks

REITs are a great way to diversify your portfolio. But investing in only a single REIT may leave you exposed to sector-specific risks. Most REITs allocate a large part of their holdings to a single sector, like hospitality or retail. But hospitality REITs are much more sensitive to economic downturns than residential REITs. When you invest in both types of REIT, you lower your overall risk.

Reasons to Invest in REITs

REITs can give your portfolio the muscle to weather an economic slowdown. You’ll be able to invest in real estate without the hassle of maintaining an immovable property and without having to commit a large amount of money.

If you’re a long-term investor with adequate surplus funds, you should consider investing in a REIT. You should also be aware of the risks before you invest. But if you already have equity, debt, and gold in your portfolio and you’re ready to diversify further, the investment opportunity that REITs offer is a compelling one.

Frequently Asked Questions

Should I invest in REITs during a recession?

REITs strengthen your portfolio with steady cash flows and are more resilient during a recession than stocks. If prices of fundamentally strong REITs plunge during a recession, this may be a good opportunity to invest in them. Regardless of economic conditions, though, a REIT provides ample benefits for investors.

How risky are REITs?

Investing in REITs comes with several risks, especially market risk; REITs tend to be highly sensitive to changes in the interest rate. Another risk is an overleveraged balance sheet. REITs borrow money to purchase properties. If they borrow too much, financial distress may result. REITs are also vulnerable to sector-specific risks. During a pandemic, for example, the value of a hospitality REIT may depreciate significantly more than the value of a residential REIT.

How do I invest in REITs?

You can invest in a publicly traded REIT the same way you invest in a stock. REITs are listed on the TSX. You can also purchase a REIT mutual fund or a REIT exchange-traded fund (ETF) using your online brokerage account.

Alternatively, you can invest in a public non-traded REIT by directly purchasing units from the REIT company. Private REITs, however, accept funds only from accredited investors.